Should municipal bonds be a core holding for ESG investors?

It’s perhaps overlooked that social responsibility is “built in” to the vast majority of municipal bonds. This represents an opportunity for investors seeking to combine potentially robust returns with environmental, social and governance (ESG) considerations.

The importance of ESG has increased dramatically in recent years. Indeed, a recent Schroders survey found that over half of the 650 institutional investors questioned had increased their allocation to sustainable investments over the previous five years.

Although sustainability was initially applied mainly to equity allocations initially, its relevance has since grown across a wide variety of asset classes.   

How is ESG "built in" to municipal bonds?

The ESG opportunity is not just limited to so-called municipal “green bonds”. These fund environmentally friendly projects in areas such as public transportation, renewable energy, pollution control, and affordable housing.

While they have gained traction in recent years, the market remains extremely concentrated. The top ten issuers of municipal green bonds accounted for 50% of the total volume over the past five years and the largest issuer accounts for nearly 20%. Furthermore, total issuance in green labeled municipals was $4.9 billion in 2018, a steep decline compared to the nearly $10 billion reported in 2017.

US municipal green bond issuance

Source: S&P Global Ratings

But just because a municipal bond isn’t labelled “green”, it does not mean it doesn’t incorporate ESG considerations.

The $3.8 trillion US municipal market is vital in funding key projects around the country. Many provide the opportunity to allocate to assets aligned with ESG priorities. Municipal debt proceeds often contribute to positive social and environmental improvement. State and local governments are essential to developing and maintaining both physical infrastructure (water & sewers, bridges, mass transit, roads & bridges) and social infrastructure (education, health care). 

Projects can be implemented both as proactive attempts to manage ESG risks or “after the fact” in hopes to avoid similar problems in the future. 

As an example, an authority in New York City recently issued debt to address specific climate change resilience projects following the damage caused by Hurricane Sandy. The area was damaged due to flooding and storm surge, and the main focus of the funding is to create a network of barriers well above sea level in neighborhoods that are susceptible to flooding. This is just one example of how municipal bonds fund projects around the country that are inherently ESG-focused.

Strong fundamentals remain key

This does not of course mean that ESG analysis should replace or even diminish the importance of traditional credit analysis. The ESG research we undertake in municipal bond investing is integrated with our fundamental research and looks deeper than a simple sovereign perspective. 

Working with Schroders’ Data Insight Unit, we have developed a proprietary ESG municipal model. It examines and assesses regional, state and local issuers based on 42 unique ESG factors from a variety of sources, including several proprietary metrics. 

As with fundamental municipal bond research, we turn anecdote into evidence while balancing sustainability with valuation. Our ESG model is one of the many tools our analysts use to reach a credit opinion on an issuer. 

Municipals have historically been a popular investment alternative due to often beneficial tax treatment for investors as well as the generally high credit quality of the market. But more recently, investors are seeing the viability of the municipal market as a way to make an impact in communities, instead of traditional philanthropy efforts.